Anatomy of the Financial Crisis with comments on Acemoglu, Brunnermeier, El-Erian,

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Anatomy of the Financial Crisiswith comments
onAcemoglu, Brunnermeier, El-Erian,
PortesJeffrey FrankelHarpel Professor of
Capital Formation GrowthHarvard Kennedy
School

• Meeting of Commission on Growth Development
• at Center for International Development, April
  20-21, 2009

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Six root causes of financial crisis

• 1. US corporate governance falls short
• E.g., rating agencies
• executive compensation
• options
• golden parachutes
• 2. US households save too little, borrow too
  much.
• 3. Politicians slant excessively toward
  homeownership
• Tax-deductible mortgage interest, cap.gains
• FannieMae Freddie Mac
• Allowing teasers, NINJA loans, liar loans

MSN Money Forbes
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Six root causes of financial crisis, cont.

• 4. Starting 2001, the federal budget was set on
  a reckless path,
• reminiscent of 1981-1990
• 5. Monetary policy was too loose during 2004-05,
• accommodating fiscal expansion, reminiscent of
  the Vietnam era.
• 6. Financial market participants during this
  period grossly underpriced risk
• risks
• housing crash,
• crash,
• oil prices,
• geopolitics.

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Current account imbalances

• Richard Portes Global Imbalances caused
  crisis.
• gt low volatility and interest rates gt leverage.
• I disagree.
• I view low US National Saving as main source of
  CA.
• I agree with Richard this crisis is not the
  feared US sudden stop
• Thats the next crisis.
• But then why interest rates low? Easy money.
  (Like 1960s.)
• Many disagree (My 9 Reasons for Growth
  Commission)
• Global savings glut hypothesis (Bernanke)
• But measured world saving did not rise in this
  decade.
• Bretton Woods II (Dooley, Garber) .
• But BW I operated for only 14 years. Were near
  the end.
• US offers the high-quality assets. (Forbes,
  Gourinchas, Caballero..)
• Not really. Was clear in 2001 (Enron)

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But I would think herd mentality the opposite
of heterogeneous views -- would be the bigger
problem.
Yes. Note time-varying variance itself gives
fat tails.
Yes. We thought securitization of mortgages
would spread the risk. But it spread risk like
a virus !
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I would like to suggest a fourth new idea in
volatility When using Black-Scholes or other
formulas to price options (VIX) or bond spreads
(corporate bonds), analysts simply plug in
variance estimated from the recent past.
During 2004-2006, lagged variance was low, tho
forward-looking risk was high.
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As Adrian Brunnermeier point out (p.5),

• After a string of good news, risk seems tamed,
  but, when a new tail event occurs, the estimated
  risk measure may sharply increase. This problem
  is most pronounced if the data samples are short.
  Hence, regulatory requirements that are
  naively based on estimated risk measures would be
  stringent during a crisis and lax during a boom.
  This introduces procyclicality exactly the
  opposite of the goal of effective regulation.

I couldnt agree more. But (i) Does this
require that tail events are asymmetrically
negative? (ii) If so, could the causality run
from a variance innovation, via the risk premium,
to a fall in asset prices, instead of the other
way?
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Origins of the financial/economic crises
Homeownership bias
Predatory lending
Excessive complexity
MBSs
Foreign debt
CDSs
CDOs
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
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The return of Keynes

• Keynesian truths abound today
• Origins of the crisis
• The Liquidity Trap
• Fiscal response
• Motivation for macroeconomic interventionto
  save market microeconomics
• International transmission
• Need for macroeconomic coordination

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• The origin of the crisis was an asset bubble
  collapse, loss of confidence, credit crunch.
• like Keynes animal spirits or beauty contest .
• Add in von Hayeks credit cycle,
• Kindleberger78 s manias panics
• the Minsky moment,
• Fishers debt deflation.
• It was not a monetary contraction in response to
  inflation as were 1980-82 or 1991.
• But, rather, a credit cycle 2003-04 monetary
  expansion showed up only in asset prices. (Borio
  of BIS.)

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Financial regulation
Good for Daron !
True. But if we dont draw up an informed list,
politicians will come up with a worse one.
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• Desirable longer-term financial reforms
• Executive compensation
• Compensation committee not under CEO. Maybe
  need Chairman of Board.
• Discourage golden parachutes options, unless
  truly tied to performance.
• Securities
• Regulatory agencies In US, merge SEC CFTC?
• Create a central clearing house for CDSs .
• Credit ratings
• Reduce reliance on ratings. AAA does not mean
  no risk.
• Reduce ratings agencies conflicts of interest.
• Lending
• Mortgages
• Consumer protection, incl. standards for mortgage
  brokers
• Fix originate to distribute model, so lenders
  stay on the hook.
• Banks
• Regulators shouldnt let banks use their own risk
  models (VAR)
• should make capital requirements less
  pro-cyclical .
• Extend bank-like regulation to near banks.

Heavy overlap with Richard Portes list, FT,
11/11/08
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I always thought CoVar stood for Covariance.
But that is no more nor less confusing than
VAR standing for Value at Risk instead of either
Variance or Vector AutoRegression. In fact
CoVaRiance rather captures the spirit of the idea.
Adrian Brunnermeier make the sensible point
that regulators should worry about how much a
bank contributes to systemic risk (CoVaR), more
than just own risk (VaR). Analogous to a CAPM
for regulators.
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Lehman Brothers, whose failure inflicted maximum
adverse effect on the financial system in Sept.
2008, shows up with almost the highest risk
rating by CoVaR, but also by VaR.
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I would phrase it We have learned something we
should have already known -- financial markets
need a lot of regulation, but market capitalism
still works best in the real economy.
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Motivation for macroeconomic intervention

• The view that Keynes stood for big government is
  not really right.
• He wanted to save market microeconomics from
  central planning, which had allure in the 30s
  40s.
• Remember, Bretton Woods blessed capital controls
  and free trade.
• Some on the Left today reacted to the crisis
  election by hoping a new New Deal would overhaul
  the economy.
• My view faith in the unfettered capitalist
  system has been shaken
  with respect to financial markets, true
  but not with respect to the rest of the economy
• Obamas economics are centrist, not far left.

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• International transmission remains as powerful as
  ever (no de-coupling)
• Consistent with old-fashioned Keynes-Meade-Mundel
  l-Fleming transmission via trade balances.

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International coordinationof fiscal expansion?

• As in the classic Locomotive Theory
• Theory in the Nash non-cooperative equilibrium
  each country holds back from fiscal
  expansionfor fear of adverse trade deficits.
• Solution A bargain where all expand together.
• In practice example of Bonn Summit, 1978
• didnt turn out so well,
• primarily because inflation turned out to be a
  bigger problem than realized ( the German world
  was non-Keynesian).
• Inflation is less a problem this time. The
  Germans are the same.

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Multilateral initiatives

• Hold the line against protectionism
• Attempts at multilateral reform
• More inclusion of developing countries
• Locus shifted from G7 to G20 at London meeting
  (April).
• The IMF and World Bank
• Reallocation of shares
• Break US-EU duopoly on MD President
• Tripling of size of IMF, incl. new SDR issue (a
  la Keynes)
• Regulatory reform.
• Reduce procyclical Basel capital requirements
  FSF .
• Coordinated expansion? Failed at London G-20.
• As had cooperation in 1933 (London Monetary
  Economic Conference)

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USfiscal stimulus looks the largest of the
G-10.
than the US
But most others have larger automatic
stabilizers
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Mohamed El-Elrian Mike Spence,Essential Task
for G20 Leaders is a Cinema Trip to See A
Beautiful MindThe Daily Telegraph, March 30,
2009

• Apparently Mohamed and Mike think the producers
  of that movie took the opportunity to teach the
  audience the simple principle of the prisoners
  dilemma. A reasonable inference.
• But thats not how I remember the
  movie.Hollywood doubts the analytical
  aptitude/interests of the public.

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Appendices

• Origins of the crisis
• The US recession
• Transmission to rest of world
• Global forecast
• The US policy response
• Monetary easing
• Financial repair
• Fiscal expansion
• Global current account imbalances
• Implications of the crisis for the status of the
  dollar
• Adjustment in surplus countries
• End of the 3rd emerging markets capital boom

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Origins of the crisis

• Well before 2007, there were danger signals in
  US
• Real interest rates lt0 , 2003-04
• Early corporate scandals (Enron)
• Risk was priced very low,

• housing prices very high,
• National Saving very low,
• current account deficit big,
• leverage high,
• mortgages imprudent

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US real interest rate lt 0, 2003-04
Source Benn Steil, CFR, March 2009
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Onset of the crisis

• Initial reaction to troubles
• Reassurance in mid-2007 The subprime mortgage
  crisis is contained. It
  wasnt.
• Then, The crisis is in Wall Street, sparing Main
  Street. It didnt.
• Then de-coupling The US turmoil will have
  less effect on the rest of the world than in the
  past. It hasnt.
• By now it is clear that the crisis is
• the worst in 75 years,
• and is as bad abroad as in the US.

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US Recession

• In December 2008, NBER Business
• Cycle Dating Committee proclaimed
• US recession had started in December 2007.
• As of March 2009, the recessions length ties the
  postwar record of 1981-82 (16 months).
• Recovery unlikely before late 2009
• gt recession is already longest since 1930s.
• Likely also to be as severe as oil-shock
  recessions of 1974 and 1980-82.

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BUSINESS CYCLE REFERENCE DATES BUSINESS CYCLE REFERENCE DATES  Source NBER
Peak Trough Contraction
Quarterly dates are in parentheses Quarterly dates are in parentheses Peak to Trough
August 1929 (III)May 1937 (II)February 1945 (I)November 1948 (IV)July 1953 (II)August 1957 (III)April 1960 (II)December 1969 (IV)November 1973 (IV)January 1980 (I)July 1981 (III)July 1990 (III)March 2001 (I)December 2007 (IV) March 1933 (I)June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)February 1961 (I)November 1970 (IV)March 1975 (I)July 1980 (III)November 1982 (IV)March 1991 (I)November 2001 (IV) 431381110810111661688
Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles) Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles)   1710
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US employment peaked in Dec. 2007,which is the
most important reason why the NBER BCDC dated
the peak from that month. Since then, 5 million
jobs have been lost (4/3/09).
Payroll employment series Source Bureau of Labor
Statistics
Payroll employment series Source
Bureau of Labor Statistics
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My favorite monthly indicatortotal hours worked
in the economy
It confirms US recession turned severe in
September, when the worst of the financial
crisis hit (Lehman bankruptcy)
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The US recession so far is deepcompared to past
and to others
Source IMF, WEO, April 2009
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Recession was soon transmittedto rest of world

• Contagion Falling securities markets
  contracting credit.
• Especially in those countries with weak
  fundamentals Iceland, Hungary Ukraine
• Or oil-exporters that relied heavily on high oil
  prices Russia
• But even where fundamentals relatively strong
  Korea, Brazil
• Some others experiencing their own housing
  crashes Ireland, Spain
• Recession in big countries was soon transmitted
  to all trading partners through loss of exports.

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International Trade has Plummeted
Source OECD
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The recession has hit more countries than any in
60 years
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Forecasts
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Interim forecast
OECD 3/13/09
Forecast for 2009 - 3 ½
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World Recession

• No generally accepted definition.
• A sharp fall in Chinas growth from 11 is a
  recession.
• Usually global growth lt 2 is considered a
  recession.
• The World Bank now (March) forecasts negative
  global growth in 2009,
• for the first time in 60 years.

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Unemployment rates are rising everywhere
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Do we know this wont be another Great Depression?

• One hopes we wont repeat the mistakes of the
  1930s.
• Monetary response good this time
• Financial regulation we already have bank
  regulation to prevent runs. But it is
  clearly not enough.
• Fiscal response OK, but constrained by
  inherited debt. Also Europe was unwilling to
  match our fiscal stimulus at G-20 summit.
• Trade policy Lets not repeat Smoot-Hawley !
• E.g., the Buy America provision
• Mexican trucks

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The Fed certainly hasnt repeated the mistake of
1930s letting M1 fall.
2008-09
Source IMF, WEO, April 2009Box 3.1
1930s
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U.S. Policy Responses

• Monetary easing is unprecedented,
  appropriately. But it has largely run its
  course
• Policy interest rates 0. (graph)
• The famous liquidity trip is not mythical after
  all.
• As Krugman others warned us re Japan in 90s.
• lending, even inter-bank, builds in big
  spreads
• since mid-2007, not just since September 2008.
  (graph)
• Now aggressive quantitative easing, as the Fed
  continues to purchase assets not previously
  dreamt of.

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Source OECD
Major central banks have cut interest rates
sharply.
43
Bank spreads rose sharplywhen sub-prime mortgage
crisis hit (Aug. 2007) and up again when Lehman
crisis hit (Sept. 2008).
Source OECD, Datastream
44
Corporate spreads between corporate government
benchmark bonds zoomed after Sept. 2008
US

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Policy Responses, continued

• Obama policy of financial repair
• Infusion of funds has been more conditional,
• vs. Bush Administrations no-strings-attached.
• Some money goes to reduce foreclosures.
• Conditions imposed on banks that want help
• (1) no-dividends rule,
• (2) curbs on executive pay,
• (3) no takeovers, unless at request of
  authorities
• (4) more reporting of how funds are used.
• But so far they have avoided nationalization of
  banks

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Policy Responses -- Financial Repair, cont.

• Secretary Geithner announced PPIP 3/23/09
  Public-Private Partnership Investment Program
• When buying toxic or legacy assets from
  banks,
• their prices are to be set by private bidding
  (from  private equity, hedge funds, and others),
  
• rather than by an overworked Treasury official
  pulling a number out of the air and risking that
  taxpayers grossly overpay for the assets, as
  under TARP.  

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Policy Responses -- Financial Repair, cont.

• How much money is the government putting into
  the PPIP?
• designed to be enough to attract participants,
  but not more.
• From the Treasury (already set aside under TARP),
  leveraged courtesy of FDIC Fed.
• Taxpayers
• share equally with new private investors in
  upside,
• but admittedly bear all the downside risk.
• Nationalization could have been a lot more
  expensive.

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The PPIP was attacked from both sidesin part due
to anger over AIG bonuses, etc.
FT, Mar 25, 2009
But the stock market reacted very positively, and
some respected commentators are supportive.
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Policy Responses, continued

• Unprecedented US fiscal expansion.
• Obama proposed an 825 expansion
• Version passed by Congress was just a bit worse.
  
• Good old-fashioned Keynesian stimulus
• Even the belief that spending provides more
  stimulus than tax cuts has returned
• not just from Larry Summers,
  for example,
• but also from Martin Feldstein.

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Fiscal responseTimely, targeted and temporary.

• American Recovery Reinvestment Plan includes
• Aid to states
• education,
• Medicaid
• Other spending.
• Unemployment benefits, food stamps,
• especially infrastructure, and
• Computerizing medical records,
• smarter electricity distribution grids, and
• high-speed Internet access.

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Fiscal stimulus also included

• Tax cuts
• for lower-income workers (Making Work Pay)
• EITC,
• child tax credit.
• Fix for the AMT (for the middle class).
• But soon will need to return toward fiscal
  discipline
• Let Bushs pro-capital tax cuts expire in 2011.
• Economists want to substitute energy taxes for
  others.

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The next crisis

• The twin deficits
• US budget deficit gt current account deficit
• Until now, global investors have happily financed
  US deficits.
• The recent flight to quality paradoxically
  benefited the ,
• even though the international financial crisis
  originated in the US.
• For now, US TBills are still viewed as the most
  liquid riskless.
• Sustainable?
• How long will foreigners keep adding to their
  holdings?
• The US can no longer necessarily rely on support
  of foreign central banks, either economically or
  politically.

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The 2007-08 financial crisis has probably further
undermined US monetary hegemony in the long run

• US financial institutions have lost credibility
• Expansionary fiscal and monetary policy may show
  up as depreciation in the long run.
• The long slow decline of the as an
  international reserve currency may accelerate.

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Simulation of central banks of reserve currency
holdings Scenario accession countries
join EMU in 2010. (UK stays out),
but 20 of London turnover counts toward Euro
financial depth, and currencies
depreciate at the average 20-year rates up to
2007. From Chinn Frankel (Int.Fin., 2008)
Simulation predicts may overtake as early as
2015
Tipping point in updated simulation 2015
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Historical precedent (1914-1956)
The 2001-2020 decline in international currency
status for the would be only one small part of
a loss of power on the part of the US. But
A loss of s role as 1 reserve currency could
in itself have geopolitical implications.

• With a lag after US-UK reversal of ec. size net
  debt, passed as 1 international currency.
• Imperial over-reach the British Empires
  widening budget deficits and overly ambitious
  military adventures in the Muslim world.

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• Precedent The Suez crisis of 1956 i
• is often recalled as the occasion on which
  Britain was forced under US pressure to abandon
• its remaining imperial designs.
• But recall also the important role played by a
  simultaneous run on the and the American
  decision not to help the beleaguered currency.
• i Frankel, Could the Twin Deficits Jeopardize
  US Hegemony, Journal of Policy Modeling, 28,
  no. 6, Sept. 2006.  At http//ksghome.harvard.e
  du/jfrankel/SalvatoreDeficitsHegemonJan26Jul.pdf
  . Also The Flubbed Opportunity for the
  US to Exercise Global Economic Leadership  in
  The International Economy, XVIII, no. 2, Spring
  2004 at http//ksghome.harvard.edu/jfrankel/Flu
  bJ23M2004-.pdf

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Be careful what you wish for!US politicians
have not yet learned how dependent on Chinese
financing we have become.
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In the short run, however, the financial crisis
has caused a flight to quality which apparently
still means a flight to US.

• US Treasury bills are more in demand than ever,
  as reflected in very low interest rates.
• The appreciated in 2008, rather than
  depreciating as the hard landing scenario had
  predicted.
• gt The day of reckoning had not yet arrived.
• Recent Chinese warnings may be a turning point
• Premier Wen worried US T bills will lose value.
• PBoC Gov. Zhou proposed replacing as
  international currency.

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Global Current Account Imbalances may now be
forced to adjust

• US deficit will likely diminish,
• though adjustment requires depreciation.
• Who must take corresponding reduction in current
  account surpluses?
• Europe says Not us. Overall we are in
  balance.
• Others say Europe can expect to take a share,
  roughly proportionate to its share in world
  trade,
• IMF seems to think oil exporters will take all
  adjustment (see graph)

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Current account adjustmentUS vis-á-vis oil
exporters
(as of GWP source IMF)
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The OECD sees the -area bearing much of the
adjustment.
3/ as of GDP
Source OECD Economic Outlook, Nov. 2008.
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But emerging marketsnow have to spend some
hard-earned reserves

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3 cycles of net private capital flows to
emerging markets, by regionpeaking in 1982,
1997 and 2008
Source Capital Flows to Emerging Market
Economies, IIF, 1/27/09.
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Capital flows to emerging marketspeaked in 2007
from EM Fund Flows, Citi, December 2008
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Source Benn Steil, Lessons of the Financial
Crisis, CFR, March 2009
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BRIC growth has disappeared
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Jeffrey FrankelJames W. Harpel Professor of
Capital Formation GrowthHarvard Kennedy School

• http//ksghome.harvard.edu/jfrankel/index.htm
• Blog http//content.ksg.harvard.edu/blog/jeff_fra
  nkels_weblog/